A market-based credit system, however, relies on market liquidity and hence ultimately on dealer of last resort to ensure the continued flow of credit. Just as the Fed adapted, in its first fifty years, to the rise of a market-based system of government credit, the Fed's present task is to adapt to the rise of a market-based system of private credit. The Fed's shifting role during the crisis can be understood as the first steps toward that adaptation.

I am also reading the latest Journal of Economic Literature, with an article by Gary Gorton and Andrew Metrick. I will quote from an earlier, ungated version. They write,

The central management of cash pools refers to the aggregation (or pooling) of cash balances from all subsidiaries worldwide in the case of global corporations, or all funds (including mutual and hedge funds and separate accounts) in the case of asset managers. Furthermore, the investment decisions that pertain to pooled balances are performed by a single decision maker (typically a treasurer) and through a fund that is a single legal person, but one that manages the cash balances of many legal persons" (p. 5; emphasis in original). Pozsar documents a striking rise in the funds managed by these pools, from about $200 million in 1990 to nearly $4 trillion on the eve of the crisis.

...By the end of 2007, about 40 percent of [asset-backed commercial paper] programs were in a run and unable to finance themselves in their traditional short-term markets.

...It is important to note that haircuts rose — and prices fell — for many assets that had no direct connection to subprime securities...the value of nonsubprime assets moved closely with measures of distress in interbank funding markets and not with an index of default risk on subprime securities.

I have a visceral, negative reaction to this line of thinking. My issues include:

1. Gary Gorton has a strong personal interest in showing that this was a panic unrelated to fundamentals. He was a consultant to AIG Financial Products, and he claimed that they would never lose a dime on their credit default swaps. Maybe he is the best person to sift through everything written about the financial crisis to present the definitive story. And maybe Jeffrey Skilling is the best person to sift through everything written about Enron to present the definitive story. But one can be skeptical. In fact, I wonder whatever happened to AIG Financial Products. AIG as a whole apparently survived, but was that because profits in other lines offset losses at AIG FP, or did AIG FP actually come out all right by itself? That would be an interesting story for someone to pursue.

2. The story of the financial crisis as a liquidity crisis is not satisfying in a number of respects. In other liquidity crises, such as the Penn Central bankruptcy, actions by the Fed served to restore confidence in the market and avoid macroeconomic distress. In this case, four years later, the private mortgage-backed securities market has not come back, and the macroeconomic distress remains. To me, this suggests that something more was going on than a short-term panic.

3. You know my simple description of financial intermediation, which is that it consists of balance sheets with long-term risky assets and short-term riskless liabilities. This allows the nonfinancial sector to issue long-term, risky liabilities and hold short-term riskless assets. A crucial question concerns what is the appropriate scale for financial intermediation. Beyond the scale that is facilitated by diversification and specialization in risk analysis, the expansion of financial intermediation is based on deception--convincing customers that the financial intermediary's portfolio is lower risk than it really is. Mehrling, Gorton, and Metrick assume away deception. Implicitly, the scale of financial intermediation before the crisis was approximately correct, and the scale now is too little. In my view, the scale of financial intermediation before the crisis was excessive, perhaps by an order of magnitude, and even today I worry that financial-sector balance sheets and profits are bloated relative to the real economy.

I don't have a problem with Gorton and company expressing their point of view. However, I find myself angered seeing this point of view anointed by the Journal of Economic Literature as definitive. I believe that the profession ought to be considering the broadest possible list of "suspects" in the case of the financial crisis. Instead, the establishment is all too eager to string up a "panic in the shadow banking system" as the culprit, and it is all to eager to dismiss policies that contributed to what I view as financial intermediation run amok.

This finding does not support broadbrush picture painted by Gorton and Metrick that the expansion of repo drove the large shadow-banking system and the subsequent run on repo caused its collapse. The short-term funding of securitized assets through ABCP and direct investments by money market investors is an order of magnitude larger than repo funding, and the contraction in ABCP is an order of magnitude larger than the run on repo. A picture that emphasizes the role of short-term debt, through both ABCP and repo, driving the expansion and collapse of the shadow banking sector is more consistent with our data.

We find evidence supportive of an alternative channel through which the run on repo may have contributed to the crisis. Troubles in funding securitized assets with repo may have been a major factor in the problems of some systemically important dealer banks that were most heavily exposed to these assets. In this context, our results highlight that the distinction between non-bank to dealer repo lending (which is a source of net funding for the shadow banking system) and interdealer repo (which reallocates liquidity within the shadow banking system)

Where does this leave the story? The authors write,

The picture that emerges from these findings looks less like a traditional bank run of depositors and more like a credit crunch among dealer banks.

]

Comments and Sharing

I've also been skeptical of the Gorton story ever since I first saw Cowen link to it a few years ago, and I didn't even know about his personal connection. I think of his story as a description of the market mechanics when it was too late to change course, rather than any kind of root cause analysis.

I will vouch for Gary Gorton as a man of very high integrity. He surely did not see the 2008 crisis, but neither did most people (including Robert Shiller). Everyone's using hindsight, as even those who called this correctly didn't think it play out as it did. His insight is so illuminating because 1) he had written extensively on bank runs his entire professional life and 2) he had unmatched access to a key focal point of stress in the system,ad 3) it's a novel phenomenon (shadow bank runs).

"Beyond the scale that is facilitated by diversification and specialization in risk analysis, the expansion of financial intermediation is based on deception--convincing customers that the financial intermediary's portfolio is lower risk than it really is."

Run don't walk to read the always brilliant Steve Randy Waldman on the *necessity* of opacity in finance, and how to ameliorate the ill effects of that necessary opacity. Heady stuff:

http://www.interfluidity.com/v2/2812.html

"In my view, the scale of financial intermediation before the crisis was excessive, perhaps by an order of magnitude, and even today I worry that financial-sector balance sheets and profits are bloated relative to the real economy."

Roger that. Time to join Mankiw's Pigou Club? If you want less of something, tax it.

“[S]omething more was going on than a short-term panic.” Sure—it was a longer-term panic! (We’re still “panicking”—at least, we’re still very nervous.) Actions by the Fed ended previous panics, but this time the Fed--the Bernanke Fed--wasn’t up to the task.

"In fact, I wonder whatever happened to AIG Financial Products. AIG as a whole apparently survived, but was that because profits in other lines offset losses at AIG FP, or did AIG FP actually come out all right by itself?"

Offset $100 billion in losses? Not likely. They were bailed out by the Fed, if you recall.

It's misleading to quote the Krishnamurthy paper as refuting the claims of Gorton et al that a run in the shadow banking sector was the primary event in the financial crisis. The basic point is that the shadow banking sector developed a maturity mismatch - borrowing short and lending long - that left them vulnerable to runs much like traditional banks. The solution to the problem of traditional bank runs - deposit insurance and the lender of last resort function of central banks, simply did not exist in the context of the shadow banking sector. MMMF's had no deposit guarantees and the Fed had no playbook telling it how to operate as a market maker of last resort, so it was very difficult to stop the run at first. In my view, the Krishnamurthy paper simply adds detail to this insight by locating additional problems in the ABCP market. I qoute:

"These ﬁndings are consistent with the views of many commentators that a contraction
in the short-term debt of shadow banks played an important role in the collapse of
the shadow banking sector, but they are inconsistent with the view that a run on repo
played the central role. The more signiﬁcant short-term debt contraction occurs in ABCP."

Kling's analysis, by contrast, seems more ideologically driven. It must be the government's fault right? We just haven't been looking in the right places...

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